Inflation Part I

Readers of this column understand how the Herculean government deflation fighting
effort will be inadequate. The incipient component necessary for the development
of modern bubbles and the subsequent deflation fighting effort is something
called inflation. What exactly is inflation? Mention inflation to someone and
the likely response is something akin to "prices rising", or "things cost more",
or "my dollar doesn't go as far". While the comments are valid, they are based
more on the effects of inflation rather than their true source or definition.
The view of inflation is largely pejorative until the public considers the
effects of inflation on their salaries or their assets. In these cases, having
a fatter paycheck, or witnessing home values increasing or the value of a collectible
increasing creates an entirely different feeling.

Before discussing inflation, let's first understand the terms money and wealth.
What is money? Isn't it what you have in your wallet? What about what you have
in the bank in a checking or savings account? Do we consider a 401(k) account
money? Is any of this wealth? Is the equity in my home money or wealth? Webster's
dictionary from 1968 says,

Money: Standard pieces of gold, silver, copper, nickel etc.
stamped by government authority and used as a medium of exchange and a measure
of value.

The online Webster's dictionary reads,

Money: Something (such as coins or bills) used as a way to pay for
goods and services and to pay people for their work. A person's wealth. The
money that a person has

Notice how the Webster definition changed? They even use the word money to
define money!

What is wealth? Is it something you possess? The 1968 Webster's publication
suggests,

Wealth: Much money or property.

Adam Smith in his work, The Wealth of Nations, said that wealth was "the
annual produce of the land and labour of the society." In my publications I
define money and wealth as follows,

Wealth: A material item produced by human effort having exchange value.
Exchange value means it can be traded or substituted for something else.

Money: A medium of exchange, that is a unit of account (something measurable),
and a direct store or representation of wealth.

Notice how my definition of money differs from the modern Webster's definition.
My definition adds "a direct store or representation of wealth". This
distinction is largely responsible for what we term inflation. In other words,
our money is still a medium of exchange and measurable but its representation
of wealth has changed.

Why do we need money? Without money all of our commercial or even personal
financial transactions require bartering. Clearly, this adds friction to any
economy. A precondition for money is public recognition of this friction and
agreement on a unit of measure representing exchange of wealth items. We use
money for the payment of goods and services and repayment of debt.

For much of human history, tangible goods such as gold, silver, copper, brass
and seashells formed the basis of money. The initial usage of paper money was
likely in China around the time of the Tang dynasty (800 AD). The Chinese government
thought it prudent to issue paper to relieve the weight burden of precious
metal coin transport. The paper was fully redeemable for coin upon demand.
It was explicitly understood that having paper was the same as having the precious
metal coin. Thus, it satisfied our criteria for money as defined earlier. It
is important to understand that even though a piece of paper was issued as
a substitute for coins, our definition of money still held - it was a medium
of exchange, that was a unit of account and a store of value. While the paper
was not wealth per se, it represented something that was wealth (precious metal
coin).

The Chinese paper continued to satisfy our definition of money until the government
began to issue more paper money in relation to the existing coin stock. The
additional issuance of paper money did not mean Chinese society was wealthier.
On the contrary, wealth was altered since the ratio of paper to existing precious
metal coin increased making each piece of paper worth less. Wealth did not
suddenly materialize by the appearance of the extra paper. For wealth to appear
material items produced by human effort having exchange value would have to
appear as well. The only thing that appeared was more paper not backed by precious
metal coin (wealth). The result was more money in the system available to claim
existing wealth. More paper money was available to buy existing goods and services
making each piece of paper worth less and goods and services cost more.

Eventually the paper money was devalued so much that it ceased to have value,
was unacceptable and replaced by new issues. In other words, there was a loss
of confidence in the entire paper money system. The increased issuance of paper
money relative to the coin stock was an early example of what we call inflation.

What reason does a government or other operator have for increasing the supply
of paper relative to the wealth in the economy? Cui bono (who benefits)? The
relationship of money to a wealth component imparts a discipline on the system.
Those holding paper intrinsically know its value. When the relationship is
altered, the money operator has deceived the holder of the paper into thinking
it is worth more than it is. The additional paper can be used by the paper
issuer to acquire wealth or consume resources previously out of reach.

The Chinese were not unique in the sleight of hand exercise called inflation.
In the next column I will examine similar events in the history of the United
States.